CHAPTER-9

BUYING AND SELLING

Endowment: what consumer already has before going to the market.
Gross demand: amt of the consumer that the consumer actually ends up
consuming.
Net demand: difference between what the consumer ends up with i.e. gross
demand and the initial endowment of goods.
Gross demand= always positive
Net demand= may be positive or negative
If net demand is negative- consumer wants to consume less- he
wants to supply that good
Negative net demand is simply an amt supplied

THE BUDGET CONSTRAINT

The value of the bundle of goods that a consumer goes home must be
equal to the value of bundle of goods that he came with.
px+px=p+p
in terms of net demand:
p(x-)+p(x-)=0
if (x-) is positive then the consumer is a net buyer or net demander of
good 1; if it is negative he is a net seller or net supplier.
The value of what the consumer buys must be equal to the value of what
he sells.

The location of line can be determines by the following simple observation:

the endowment bundle is always on the budget line.
In the above diagram x> and x<, so the consumer is a net buyer of
good 1 and a net seller of good 2.

CHANGE IN BUDGET CONSTRAINT

Due to change in price
Due to change in endowment

change in price

when money income is determined by the value of the endowment : if the

value of a good you are selling changes , your money income will certainly
change. Thus in the case where the consumer has an endowment,
changing prices automatically implies changing income.

If the price of good 1 decreases, bL becomes flatter. Since endowment

bundle is always affordable, this means that the bL must pivot around the
endowment.
Consumer is initially a seller of good 1 and remains a seller of good 1 even
after the price has decreased.

If the consumer remains seller, the his new consumption bundle is lower
than his origina consumption bundle. This part of new budget line is inside
the original budget set: all of these choices were open to the consumer
before the price changed.

Therefore by revealed preferences all of these choices are worse than the
original consumption bundle.

Changing the endowment

If endowment changes from (,) to (,) such that:

this inequality means that the new endowment is worth less than the old
endowment- the money income that the consumer could achieve by selling
her endowment is less.

This is same as reduction in money income. Consumer is definitely worse

off with the new endowment than she was with the old endowment, since
her consumption possibilities have been reduced.

Her demand for each good will change according to whether that good is a
normal good or not.

If the value of endowment increases the bL shifts outward in a parallel way,

the consumer must be made better off. Algebraically if endow changes from
to
and
Then the consumers new budget set must be
preferred to the optimal choice given the old endow.

Just because a consumption bundle had a higher cost than another didnt
mean that it would be preferred to other bundle. But that only holds for a
bundle that must be consumed. If a consumer can sell a bundle of goods
on a free market at constant prices then he will prefer a higher valued
bundle to a lower valued bundle, simply because a higher valued bundle
gives him more income and thus more consumption possibilities.

Therefore an endowment that has higher value will always be preferred to

an endowment with a lower value.

OFFER CURVES AND DEMAND CURVES

Price offer curves depict those combinations of both gods that may be
demanded by a consumer and that demand curves depict the relationship
between the price and the quantity demanded of some good.

The offer curve will always pass through the endowment, because at some
price the endowment will be a demanded bundle; that is, at some prices the
consumer will optimally choose not to trade.
The consumer may decide to be a buyer of good 1 for some prices and a
seller of good 1 for other prices. Thus the offer curve will generally pass to
the left and to the right of the endowment point.
The demand curve illustrated in the above figure is the gross demand
curve- it measures the total amount the consumer chooses to consume of
good 1.
The net demand for good 1 will typically be negative for some prices. This
will be when the price of good 1 becomes so high that the consumer
chooses to become seller of good 1. At some prices consumer switches
between being a net demander to being a net supplier of good 1.

Supply is just as a negative demand.

Algebraically, the net demand for good 1,
between the gross demand

x1

p1, p 2

d1

p1, p 2

), is the difference

) and the endowment of good 1,

when this difference is +ve that is, when the consumer wants more of the
good than he or she has:

The net supply curve is the difference between how much the consumer
has of good 1 and how much he wants when this difference is positive:

If the gross demand curve is always downward sloping, then the net
demand curve will be downward sloping and the supply curve will be
upward sloping.
If an increase in the price makes the net demand more negative, then the
net supply will be more positive.

THE SLUTSKY EQUALTION REVISITED

The case where endowment is given necessarily involves a change in
money income, since the value of endowment will necessarily change
when a price changes.
Slutsky eqn decomposes the change in demand due to a price change into
a substitution effect and an income effect. The income effect is due to tha
change in purchasing power when price changes.
Now, purchasing power has two reasons to change: the first one is when a
price falls, you can buy just as much of a good as you were consuming
before and have some extra money left over. This is called as ordinary
income effect.
Second effect is when the price of good changes, it changes the value of
the endowment and thus changes the money income. This is called as
endowment income effect.
Slutsky equation will take the form:
Total change in demand= change due to substitution effect+ change in
demand due to ordinary income+ change in demand due to endowment
income effect.
x 1 = total change in demand

x 1 = change in demand due to the substitution effect

m

x 1 = change in demand due to the ordinary income effect

When the price of the endowment changes, income will change, and this
change in income will induce a change in demand. Thus the endowment
income effect will consist of two terms:
Endowment income effect= change in demand when income changes
the change in income when price changes.
Second effect;

The first term is just how demand changes when income changes.
m

x1
m

= the change in demand divided by the change in income.

Thus the endowment income effect is given by:

Final form of slutsky equation:

Sign of substitution effect is always negative. Let us suppose that the good
is a normal good, so that

x1m
m

>0 then the size of the combined income

effect depends on whether the person is a net demander or net supplier of

the good.
If he is net demander and its price increase, then the consumer will buy
less of it
If he is net supplier, then the sign of the total effect is ambiguous: it
depends on the magnitude of the (positive) combined income effect as

compared to the magnitude of the (negative) substitution effect.

The total change in the demand for good 1 is indicated by the movement
from A to C. this is the sum of three separate movements: the substitution
effect, which is the mvt from A to B, and two income effects.
The ordinary income effect, which is the mvt from B to D, is the change in
demand holding money income fixed.
There is now an extra income effect: because of the change in the value of
endowment, money income changes. This change in money income shifts
the budget line back inward so that it passes through the endowment

bundle. The change in demand from D to C measures this endowment

income effect.

LABOUR SUPPLY
The consumer can choose to work a lot and have relatively high
consumption, or can choose to work a little and have a small consumption.
The amount of consumption and labour will be determined by the
interaction of the consumers preferences and the budget constraint.

The budget constraint

Assumption: consumer has some money income M that he receives
whether he works or not. This amount is called as the consumers non
labour income.
C= amount of consumption the consumer has
p= price of the consumption
w= wage rate
L= amount of labour supplied.
Budget constraint:
pC= M + wL
the value of what the consumer consumes must be equal to his non labour
income plus his labour income.

= amount of labour time.

Let us define, C=M / p the amount of consumption that the consumer

would have if he didnt work at all. That is C is her endowment of
consumption, so;

The variable LL can be interpreted as the amount of leisure- that is,

time that isnt labour time.
Let R = leisure
Then the amount of time available for leisure is R = L , and the budget
constraint;

INTERPRETATION- It says that the value of a consumers consumption

plus her leisure has to equal the value of endowment of consumption and
his endowment of time, where her endowment of time is valued at her
wage rate. The wage rate is not only the price of labour, it is also the price
of leisure.
wage rate is the opportunity cost of leisure
the right hand side of this bC is sometimes called the consumers full
income or implicit income. It measures the value of what the consumer
owns- her endowment of consumption goods and her endowment of her
own time. This is to be distinguished from the consumers measured
income, which is simply the income she receives from selling off some her
time.
This budget constraint passes through the endowment point ( L ,C ) and
has slope of /p. the endowment would be what the consumer would get
if she did not engage in market at all, and the slope of budget line tells us
the rate at which the market will exchange one good for another.

The optimal choice occurs where the MRS-the trade off between
consumption and leisure- equals /p, the real wage.
The value of the extra consumption to the consumer from working a little
more has to be just equal to the value of the lost leisure that it takes to
generate that consumption. The real wage is the amount of consumption
that the consumer can purchase if she give up an hour of leisure.

For most people the supply of labour would fall when their money
increases. In other words leisure is probably a normal good for most
people: when their money income increases, people choose to consume
more leisure.

When wage rate increases there are two effects: the return to working more
increases and the cost of consuming leisure increases.
When wage rate increase leisure becomes more expensive which by itself
leads to want less of it(substitution effect). Since leisure is a normal good
we would then predict that an increase in the wage rate would necessarily
lead to a decrease in the demand for leisure- that is increase in the supply
of labour. A normal good must have a negatively sloped demand curve.
Supply curve of leisure(normal good) must be positively sloped.
If the wage rate changes, the money income must change as well. The
change in demand resulting from a change in money income is an extra
income effect- the endowment income effect. It occurs on top of the
ordinary income effect.

In this expression substitution effect is negative, as it is always, and

R/ m

is positive since we are assuming that leisure is a normal good.

R -R is positive as well, so the sign of the whole expression is

ambiguous.
The case where an increase in the wage rate results in a decrease in the
supply of labour is represented by a backward bending labour supply
curve.
the slutsky eqn tells us that this is more likely to occur the larger is

R
-R),

that is the larger is the suplly of labour. When R =R the consumer is

consuming only leisure so an increase in the wage will result in a pure
substitution effect and thus an increase in the supply of labour.
But as labour supply increase, each increase in the wage gives the
consumer additional income for all the hours he is working, so that after

some point he may well decide to use this extra income to purchase
additional leisure- i.e. to reduce his supply of labour
When the wage rate is small, the substitution effect is larger than the
income effect, and an increase in the wage will decrease the demand for
leisure and hence increase the supply of labour.
But for larger wage rates the income effect may outweigh the substitution
effect, and an increase in the wage will reduce the supply of labour.